When it comes to investing money, there is an inherent conflict or tension about how to do it.
While some people believe in diversifying their investments, there are those who do just the opposite. In this case, they invest large amounts of money in a few, concentrated investments. The question is: Which is the better approach?
Diversification is an investment technique that uses many varied investments within one portfolio. According to diversification theory, a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any single individual investment. Diversification tries to smooth out volatility in a portfolio caused by market, interest rate, currency and geopolitical risks. In layman’s terms, don’t put all your eggs in one basket.
Although you may not get rich quickly with a diversified portfolio, over the long term you may continue to build up the value of your assets.
One and done
If Bill Gates had diversified, he would not be where he is today. If Gates had sold off his Microsoft stock 30 years ago and created a diversified portfolio, he may still have been well off but he wouldn’t be one of the richest men in the world.
This is the theory used by those investors who only buy a few different assets but put a large percentage of their wealth in them.
When it comes to diversification, many people ask why one should invest in something that you either don’t like or don’t think will appreciate in value. If an investor doesn’t think the investment will go up, what’s the point of owning it? The implication of the question is that one should only invest in something that he thinks will make money now.
What’s the answer?
There is no empirical answer to this fundamental question.
What works for some investors doesn’t necessarily work for others. There is certainly logic in investing in something you believe will move up in value. However, it is worthwhile noting that the reason people such as Bill Gates and Warren Buffet are famous is because they were so successful in their concentrated investing style. We don’t usually hear the stories of those who lost it all by this style of investing.
Back during the Internet bubble, I had a client who wanted to become a millionaire by putting all his money into Nokia stock. He got close, and then the bubble burst and so did his one-stock portfolio.
For most people, it would seem that the responsible way to grow your assets over the long run is to continue to save as well as to diversify.
Returning to the other question we asked previously of why you should invest in something that you don’t think will go up or you don’t believe in, there is no clear answer. Just because a person doesn’t like something or he doesn’t think an investment will appreciate, this doesn’t necessarily mean that that is what will actually happen. Diversification is about lowering risk, and trying to not just preserve principal but to grow it as well. Ultimately, both approaches have the same goal of significantly growing your principal over the long term. The advantage of diversification is that even if you don’t become rich, you will not end up in the poorhouse with nothing to show for years of hard work and saving.
For most investors a diversified portfolio makes sense. Most investors have neither the time nor know-how to successfully get rich by investing in a few stocks. By investing in a diversified portfolio you can both lower your risk and enhance your returns. Sounds like a good deal. Building wealth takes time. In today’s culture of instant gratification, we look to get rich quick by investing all our money in “hot stocks.” Unfortunately for most, the opposite occurs.
The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its firstname.lastname@example.org Aaron Katsman is author of the book Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing, and is a licensed financial professional both in the United States and Israel.